Comparative Advantage and Specialization

TRADE

We have learned enough about production that we can now begin our explanation of trade.

TRADE- Assumptions

Let’s assume there are two products (Food and computers).

There are two countries: Europe, South America.

TRADE the main question:

To be self-sufficient and produce everything we need

OR

To cooperate with the other country &

TRADE

Trade is beneficial if one can only produce food while the other can only produce computer.

Trade is good if Europe is better in one while South America is better in the other.– They should SPECIALIZE and trade.

TRADE

Computers Food

200 0

100 200

0 400

Some points on South America's PPC

Computers Food

400 0

200 100

0 200

Some points on Europe's PPCSome points on South America’s PPF Some points on Europe’s PPF

But what happens if one is much better in producing both computers and food?

TRADE

Computers Food

200 0

100 50

0 100

Some points on Europe's PPC

They can still benefit from trade as long as opportunity costs are different.

Computers Food

250 0

125 125

0 250

Some points on South America's PPC

A different example

Some points on South America’s PPF Some points on Europe’s PPF

Opportunity Costs

Let’s look at the extremes:

What is the opp. cost of 1 food in Europe?

100 200vs.

Opportunity Costs

If you pick to produce 100 units of food …

you give up producing 200 computers.

What is the opp. cost of 1 food in Europe?

100 200vs.

Opportunity Costs

So the opportunity cost of 100 units of food is 200 computers.

100 200vs.

The opportunity cost of 1 unit of food, then is 2 computers.

Opportunity cost of a computer in Europe? Europe could produce a maximum of 200 computers. BUT

to do so they have to give up 100 units of food.

So, the cost of 200 computers is 100 units of food.

Or, the opportunity cost of 1 computer is 0.5 of a unit of food.

So, what are opportunity costs in South America? South America could produce a maximum of 250 food

units. BUT to do so they have to give up 250 units of computer.

So, the cost of 250 units of food is 250 computers.

Or, the opportunity cost of 1 food is 1 computer.

Opportunity cost of a computer in South America? South America could produce a maximum of 250

computers. BUT to do so they have to give up 250 units of food.

So, the cost of 250 computers is 250 units of food.

That means that the opportunity cost of each unit of 1food is 1 computer.

So, what are opportunity costs?

Specialize in what your opportunity cost is lower!!!

opportunity cost of

1 computer

opportunity cost of 1

unit of food

South America 1 Food

Europe 0.5 Food1 computer

2 computers

Absolute vs. Comparative Advantage

Absolute advantage The ability of an individual, firm, or country to produce more of a good or service than competitors using the same amount of resources.

Comparative advantage The ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers.

TRADE

Computer Food Computer Food

Production 70 180 90 55

Consumption 70 180 90 55

South America Europe

NO Trade

What if there is no trade?

TRADE

Specialize and trade 66 units of food for 99 computers.

Let’s introduce trade instead.

Gains from TRADE

Computer Food Computer Food

Production 0 250 200 0

Consumption 99 184 101 66

Gain 29 4 11 11

With

Trade

South America Europe

Computer Food Computer Food

Production 70 180 90 55

Consumption 70 180 90 55

South America Europe

NO Trade

Gains from TRADEwith Graphs

computers

food

Trade

You may now ask: “But where did you come up with that they should trade 66 food units for 99 computers?”

Excellent question.

66 Food units for 99 computers is equivalent to each

1 food for 1.5 computers, right? Right.

And that comes from the opportunity cost table.

Trade will only make both countries better off if the ‘price’ in trade is between the two opp. costs.

Trade pattern

The Principle of Comparative Advantage

Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.

Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Should the United States trade with other countries?

As we all know Americans enjoy a lot of goods produced by other countries.

Imports: goods produced abroad and sold domestically.

Exports: goods produced domestically and sold abroad.